For investors these days, it can often feel like high-flying growth stocks are the only game in town when it comes to making real money in the stock market.
The Magnificent Seven stocks alone have thoroughly dominated both the headlines and the performance of the major indexes for the last two years.
But, as hard as it may be to believe, it’s a recent (and likely temporary) phenomenon. In fact, for most of the last 100 years, finding and investing in bargain stocks has led to better performance.
Analysis by Wellington Management’s portfolio manager Sean Kammann found that, from 1927 to 2020, value stocks actually outperformed growth stocks by 397 basis points (just under 4%) annually on average.
The reason it may not feel that way is largely due to recency bias. Persistent low interest rates from the Fed have skewed returns in favor of growth stocks, which are more likely to thrive on cheap capital.
In those conditions–the only conditions that many investors have ever known–solid, profitable companies simply can’t keep pace with pre- or low-revenue companies that are gobbling up market share at the cost of profitability.
And while rates have begun ticking lower, the Fed appears to be in no hurry to return to the zero-interest-rate environment of years past.
So, if we’re looking at a sustained period of higher rates that may favor value stocks over growth, what are some ways to find bargain stocks that may once again outperform?
3 Secrets to Find Bargain Stocks
The Net Current Asset Value Formula
There is no better analyst to turn to than Benjamin Graham, the father of value investing and the creator of the stock analyst profession. Mr. Graham created several investing methodologies, which are well documented in his most famous books: Security Analysis, co-authored with David Dodd in 1934, and the Intelligent Investor, which was first printed in 1949.
One of Benjamin Graham’s earliest analyses, created and tested 75 years ago, is the Net Current Asset Value (NCAV) approach. The objective of the NCAV formula is to find the minimum value a company would fetch if it was liquidated. The formula is:
Net Current Asset Value (NCAV) = cash and short-term investments + (0.75 * accounts receivable) + (0.5 * inventory) – total liabilities – preferred stock
The resulting value can then be divided by the number of common shares outstanding to find the NCAV per share. If the current stock price is less than the NCAV per share, the stock is a bargain.
Negative Enterprise Values
Identifying companies with negative enterprise values is another good way to find a bargain stock.
And it’s a little more straightforward than the Net Current Asset Value above.
Start with the market cap, then add debt and subtract cash. If the result is negative, you have a negative enterprise value stock.
In other words, if a company’s cash on hand is enough to retire all the debt outstanding and that leaves you with a cash balance that exceeds the market cap of the stock itself, you’ve got a bargain stock because it means the company is trading for less than it has in cash on hand.
It’d be a bit like buying a shoebox with $120 inside of it for $100. The value of the shoebox itself (the corporate structure) doesn’t really matter.
Our previous analysis of negative enterprise value stocks found that you’re better off avoiding financials and Chinese stocks as negative enterprise values aren’t indicative of cheap stocks in the financial sector and the risk of fraud in China is too great.
Price Multiples
The final way to find a bargain stock is one that most investors are going to be more familiar with, using price multiples.
Price multiples, such as the price-to-earnings (PE) ratio, the price-to-book value (PBV) ratio or the price-to-sales (PS) ratio, measure the price of a stock against another per-share value (earnings, sales, etc.).
Then, an investor can compare that ratio to other peer companies in the same industry and determine, relatively, which of those companies may be over or undervalued.
Because the PE ratio in particular has become a quick shorthand for whether a stock is “overpriced,” it’s important to note that not all price multiples are created equal.
Using a company’s forward PE is appropriate for comparing one tech stock against another, but it’s a poor metric for comparing financials. If you’re comparing financial companies, PBV is a more appropriate metric.
With the possibility that value stocks may be regaining the favor of Wall Street, now’s a great time to learn a few ways to find bargain stocks. And if you’re looking for expert guidance, consider a subscription to Cabot Value Investor or Cabot Turnaround Letter to get you started.
